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FRM Part II · FRM Exam Part II · Derivatives

A bank calculates a credit valuation adjustment (CVA) on an uncollateralised interest rate swap with a corporate client. Which statement best describes what the CVA represents?

CVA is the expected loss from counterparty default, measured as the market value of counterparty credit risk, and it is deducted from the risk-free value of the derivative. Own default risk is captured separately by DVA, and funding costs are captured by FVA.

  1. AThe market value of the bank's own default risk, which increases the value of its liabilities
  2. BThe expected loss from counterparty default, deducted from the risk-free value of the derivativeCorrect
  3. CThe cost of funding the initial margin posted to a central counterparty
  4. DThe premium paid to enter a credit default swap on the bank itself

Explanation

CVA is the market value of counterparty credit risk: the expected discounted loss from the counterparty defaulting while the bank has positive exposure. The derivative's value adjusted for credit is the risk-free value minus CVA. The option describing own default risk is DVA, not CVA.

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